Category: Lifetime Allowance

Pension Lifetime Allowance (LTA) decreased to £1m on 6 April 2016. In combination with previous reductions, it has fallen almost by half from its 2012 high of £1.8m. High net worth professionals like solicitors, barristers and accountants often underestimate the risk of exceeding their LTA. That might become very costly in the future. Above LTA, pension income is subject to 25% tax and lump sum a whopping 55%.

Example
Consider George. He is an accountant and has his own accounting business. He is in his 40’s, approaching halftime of his career. His pension pot is worth about £400,000. George considers himself comfortable, but not particularly rich. He’s heard the news about the falling LTA, but £1m sounds like different world. He’s nowhere near a millionaire after all, so he doesn’t need to worry about LTA.

Truth is, if George continues to contribute to his pension plan at the same rate, or (more likely) increases his contributions a little bit in the later years of his career, he can easily get dangerously close to the £1m mark, or even exceed it. This does not mean that he should stop contributing, but the sooner he becomes aware of the issue and starts planning, the wider options he has.

What are the options for senior professionals at risk of exceeding the new LTA?

LTA Protection
First, if you are likely to exceed the new reduced LTA (£1m), or already have, you can apply for LTA Protection, which is a transitional scheme to protect taxpayers from the unexpected LTA reduction. Depending on your circumstances you have two main options:

Individual Protection for those with pension pots already worth over £1m. Your LTA will be set to the lower of 1) the current value of your pension 2) £1.25m (the old LTA).

Fixed Protection for those with pension pots below £1m at the moment, but likely to exceed it in the future. Your LTA will be $1.25m, but no further contributions are allowed.

Other conditions apply and many factors must be considered when deciding whether LTA Protection is worth it in your case. Also note that a similar LTA Protection scheme has been in place for the 2014 decrease in LTA (from £1.5m to £1.25) – you can still apply until 5 April 2017.

LTA Planning Options and Alternatives
If you have higher income and want to save more than the LTA allows, the first thing to look at is an ISA. It won’t help you reduce taxes now, because it’s always after-tax money coming in, but in retirement you’ll be able to draw from your ISA without having to pay any taxes – capital gains, interest and dividends are all tax-free within an ISA. There is no lifetime allowance on ISAs, only an annual allowance, currently at £15,240 and rising to £20,000 in April 2017. Furthermore, you don’t even have to wait for retirement – you can withdraw from your ISA at any time.

Another alternative is to invest in stocks, bonds or funds directly, outside a pension plan or ISA. Capital gains, interest and dividends are subject to tax in this case, but there are relatively generous annual allowances which you can take advantage of – the most important being the CGT allowance, currently at £11,100 (the first £11,100 of capital gains in a tax year is tax-free).

These two options alone provide a huge scope for tax-free investing when planned properly. Those on higher income may also want to consider more complex solutions, such as trusts, offshore pensions or offshore companies, although the use of these always depends on your unique circumstances and qualified advice is absolutely essential – otherwise you could do more harm than good.

Conclusion
LTA planning must be taken seriously even when it seems too distant to worry about at the moment. Pensions are the cornerstone of retirement planning, but not the only tool available. With careful planning, a combination of different investment vehicles and tax wrappers is often the most efficient, especially for higher net worth professionals.

Recent years have seen some significant changes to the tax treatment and rules governing pensions and death benefits. Many of these changes have been quite favourable, bringing new freedoms and tax saving opportunities. However, these freedoms go hand in hand with responsibilities and risks. We will look at the most important challenges and ways to ensure your investments achieve the best possible performance, serve your income needs and at the same time remain tax efficient – both in retirement and when your wealth eventually passes to your heirs.

The Changes

The Government has recently changed financial and tax legislation in many areas, but there are two things which are particularly important when it comes to retirement and inheritance tax planning.

Firstly, you now have greater freedom to decide how to use your pension pot when you retire. You can take the entire pension pot as lump sum if you wish (25% is tax-free, the rest is taxed at your marginal rate), you can take a series of lump sums throughout your retirement, you can buy an annuity or get one of the increasingly popular flexible access drawdown plans.

Secondly, you now have complete freedom over your death benefit nominations. Before the reform, which came into effect in April 2015, you could only nominate your dependants (typically your spouse and children under 23). Now you can nominate virtually anyone you wish, such as your grandchildren, siblings, more distant relatives, or even people outside your family. Furthermore, the taxation of death benefits has become more favourable. If you die before 75, death benefits are tax-free (lump sum or income, paid from crystallised or uncrystallised funds). If you die after 75, death benefit income is taxed at marginal rate of the beneficiary (lump sum is subject to 45% tax, but that may also change in the near future). The reform has turned pensions and death benefits into a powerful inheritance tax planning tool.

The Challenges

While the above is all good news, there are some very important restrictions and things to watch out for. Neglecting them can have costly consequences. For instance, the Lifetime Allowance not only still applies, but has been significantly reduced in the recent years (it is only £1m now). Besides the annual pension contribution allowance it is one of the things that require careful planning long before you retire. In retirement, pension income is typically subject to income tax, which must be considered when deciding about the size and timing of withdrawals, particularly if you have other sources of income.

Asset allocation and investment management is another challenge. Maintaining a good investment return with reasonable risk is increasingly difficult in the world of record low interest rates. It is tempting to completely avoid low-yield bonds and other conservative investments in favour of stocks, but such strategy could leave you exposed to unacceptably high levels of risk, particularly in the last years before your retirement. A balanced portfolio of stocks and bonds is often the best compromise, but asset allocation should not be constant in time – it should be regularly reviewed and should reflect your changing time horizon and other circumstances.

Death benefit nominations are another area where changes in financial and life circumstances may require reviews and adjustments, particularly after the age of 75, when potential death benefits are no longer tax-free. For example, if your children are higher rate taxpayers, you may want to change the nominations in favour of your grandchildren, who may be able to draw the income at zero or very low tax rate, allowing you to pass wealth to future generations in a tax-efficient way. If you have other sources of income and are a higher rate taxpayer yourself, you may even choose to not draw from your pension at all and keep it invested to minimise total inheritance tax.

Conclusion

The above are just some of the many things to consider. Depending on your particular situation, there might be tax saving opportunities which you may not be aware of. Conversely, ignorance of little details in the legislation or mismanagement of your investments may lead to substantial losses or tax liabilities. The new freedoms (and related challenges) make qualified retirement planning advice as important as ever before.

Budget Statement 2016: Key Takeaways

Chancellor George Osborne delivered his annual Budget speech yesterday. While there are winners and losers as usual, this year’s Budget can be considered quite favourable to middle income families and savers. The pension tax relief is safe (for now) and Capital Gains Tax goes down, among other things. Whilst the Budget contained a wide range of measure, our analysis concentrates on those aspects, which are most important to our clients, namely, taxes, pensions and investments. The full speech is available here.

Personal Allowance and Higher Rate Threshold Up

The Personal Allowance, which is the amount you can earn without having to pay Income Tax, will increase from the current £10,600 to £11,000 for the 2016-17 tax year and £11,500 for 2017-18 (up from the previously announced £11,200).

The higher rate threshold will rise from the current £42,385 to £43,000 for 2016-17 and £45,000 for 2017-18. It is estimated that about 585,000 taxpayers will fall out of the 40% tax bracket as a result.

Both of these are in line with the Government’s previous promises to increase the Personal Allowance to £12,500 and the higher rate threshold to £50,000 by April 2020.

Pension Tax Relief Remains

The fears of pension tax relief cuts or other radical changes to the existing pensions system have not materialised, at least for now. In light of the loud opposition to these plans, pointing out that such measures would discourage people from saving for retirement, the Chancellor has decided to not proceed at this point. The only reference in his speech was the following:

“Over the past year we’ve consulted widely on whether we should make compulsory changes to the pension tax system. But it was clear there is no consensus.”

Of course, this does not mean the issue is safely off the table forever. The Chancellor still needs to find ways to meet his goal of “surplus by 2019-20” and pensions certainly remain among the possible targets. For the 2016-17 tax year though, the allowance stays at £40,000 (for those earning under £150,000), with pension tax relief equal to your marginal tax rate. As previously announced, the Lifetime Allowance falls to £1m effective from April 2016.

ISA Allowance £20,000 and New Lifetime ISA

While pensions have been subject to shrinking allowances in the last years, the trend has been the opposite with ISAs, apparently one of the Government’s preferred ways for people to save for retirement. This time the Chancellor has announced that the annual ISA allowance would jump to £20,000, although only from April 2017. For the 2016-17 tax year the allowance remains at £15,240, same as this year, as previously indicated.

A completely new type of ISA will be introduced in April 2017, called Lifetime ISA. Young savers will be able to contribute up to £4,000 a year and receive a 25% bonus from the Government. That is extra £1 for every £4 saved, a maximum of £1,000 per year. You must be under 40 when opening the account; you will be entitled to the bonus every year up to the age of 50, but only if you have opened an account before 40 (therefore those reaching 40 before 6 April 2017 will miss out). Furthermore, to qualify for the bonus the money must only be used either to save for retirement or to buy a home. If you withdraw cash before the age of 60 and use it for purposes other than buying a home, you will lose the bonus (including any returns on it) and pay a 5% penalty.

The Lifetime ISA is intended as an alternative to pensions for young workers (“many of whom haven’t had such a good deal from the pension system”) and will most likely further develop in the next years. With its home ownership objective it will replace the previously announced Help to Buy ISA, which remains in place until 2019 and can be transferred to the new ISA after April 2017.

Capital Gains Tax Down (Excluding Property)

Shares and other investments sold outside an ISA or pension scheme are subject to Capital Gains Tax when the annual CGT allowance (currently £11,100) is exceeded. As another welcome change to investors, the rates of CGT will drop from 18% to 10% (basic rate) and from 28% to 20% (higher rate).

Importantly, these reductions won’t apply to capital gains from property sales, which will continue to be taxed at the existing rates. This is consistent with the Government’s recent actions against Buy to Let and intended to “ensure that CGT provides an incentive to invest in companies over property”.

Other Changes

The following are some of the other announcements from this year’s Budget speech.

From April 2017 there will be two new tax-free allowances (£1,000 each) to support micro-entrepreneurs and the “sharing economy”. The first will apply to property income (such as when renting out your home), the other to trading income (such as when occasionally selling goods and services online).

Corporation Tax will decrease further than previously announced, to 17% from April 2020.

Contrary to expectations, fuel duty will continue to be frozen for sixth year in a row.

From April 2018 there will be a new levy on soft drinks with high sugar content. The proceeds will help finance more PE and sport in schools.

Last but not least, Armed Forces veterans in need of social care will be able to keep their war pensions, rather than use them to pay for care.

Conclusion

For the time being, pensions remain the primary way to save for retirement and their tax and other advantages are hard to beat by the alternatives, even with the reduced CGT. Their major downsides are the reduced Lifetime Allowance and Annual Allowance for high earners, effective from 6 April. Of course, further changes may come in the next months and years.

With 25% bonus from the Government, the new Lifetime ISA offers attractive net returns, as long as you meet the conditions. It is only £4,000 per year, but that could add up and compound over time. Even if you are too old to qualify yourself, make sure your children know and take advantage of it when it starts to be available in April 2017.

Lastly, if you are likely to exceed the CGT allowance, consider deferring the sale until 6 April where possible. Not only you will have a new allowance to use, but also CGT rates will be lower by 8 percentage points if you exceed it.